Background: My most recent Seeking Alpha article on International Business Machines (IBM) told the story: IBM's Description Of Q3 Supports My Previous Bearish Articles. How Low Can The Stock Go?
In this and prior IBM articles, I criticized the company for engaging in too much financial engineering while its actual business results were suffering. IBM's hardware division actually operated at a loss in Q3. Unfortunately, but unsurprisingly, IBM's latest response has been to engage in yet more financial engineering. Further unsurprising has been Bloomberg.com's cheerleading of this step to the point of misleading readers in various ways. This is consistent with the point of my first IBM article on Seeking Alpha, IBM And The Media Attempt To Obscure Its Declining Business Results.
My view is that in contrast to IBM's behavior, when the going gets tough, the tough get going and try harder to whip the competition, not pump the stock. Success in the former endeavor will let the stock price take care of itself.
Discussion: Bloomberg reports IBM Adds $15 Billion Buyback After Six-Quarter Sales Slump. The article misleads readers from the first sentence:
This is true but deceptive. What non-selling (i.e. loyal) shareholders require is business success. Lacking that, they do not benefit from IBM adding its buying power to that of other market participants to get selling shareholders a marginally higher price. All the remaining shareholders get from that exercise is a financially weaker company with fewer shares outstanding. If EPS happen to go higher as a result, the stock deserves a commensurately lower P/E due to less cash and/or more debt on the corporate balance sheet. IBM appears to have been underinvesting in growth. Why doesn't the board and the senior executives change that perception, not double down on share buybacks?
Bloomberg's and IBM's next error comes in the third paragraph:
Chief Executive Officer Ginni Rometty is rewarding shareholders who held on as the stock fell 7.4 percent this year through yesterday, compared with the 24 percent gain in the Standard & Poor's 500 Index. With sales dropping, the company is counting on the buyback to help reach its goal of $20 in adjusted earnings a share by 2015, up from $15.25 last year.
The whopper is that this is "rewarding" shareholders. It rewards selling shareholders. Since IBM has been adding to its net debt and has a negative tangible book value, it is in effect going to borrow money to reward these shareholders. With nominal sales and operating profits in a downtrend, how does more financial engineering reward remaining shareholders?
Answer: It does not. Again, what would reward non-selling shareholders would be a renewed commitment to more productive research and product development. Why is a commitment to R&D missing from IBM's publicity these days? (Because the company has been cutting R&D to help "make" its EPS numbers, that's why.)
My bete noire comes in the end of the above paragraph. IBM has almost bizarrely fixated on a Soviet-style set of 5-year plans to "earn" a specific dollar amount per share. Cutting R&D and staff is necessary to do this these days, and so it goes. This is not what great companies do; or at least they used to not do this. This behavior is more reminiscent of AIG raising its dividend near the end of its pre-bailout life, as its auditors were raising concerns about its internal controls well before its near-collapse later in 2008.
Later in the article, Bloomberg states:
Sales have fallen for six straight quarters, and IBM's hardware unit reported a loss for the three months that ended in September. At the same time, earnings have continued to climb.
Have earnings really continued to climb? From IBM's Q3 press release:
Pre-tax income decreased 5 percent to $4.8 billion and pre-tax margin of 20.3 percent was down 0.2 points compared with the prior-year period. Operating (non-GAAP) pre-tax income decreased 4 percent to $5.3 billion and pre-tax margin was flat compared to the year-ago period.
IBM's tax rate was 16.0 percent, down 8.6 points year over year; operating (non-GAAP) tax rate was 17.0 percent, down 7.7 points compared to the year-ago period.
The above suggests that earnings were effectively down year on year, but IBM also reported:
o GAAP Results:
- Diluted EPS: $3.68, up 11 percent;
- Net income: $4.0 billion, up 6 percent;
- Gross profit margin: 48.0 percent, up 0.6 points;...
$23.7 billion, down 4 percent, down 2 percent adjusting for currency:
Basically, IBM had a one-off very large tax benefit in Q3. Also very important is that in Q2, IBM took a "kitchen sink" writeoff for "workforce rebalancing" for the rest of 2013 in that quarter. So, severance and related costs that occurred in Q3 were placed in Q2. Sometimes GAAP is misleading. Q3 may have been one of those times.
This adjust looks like more and more types of financial engineering to me. Under GAAP, EPS rose. Define "earnings" as you will, but in a balanced fact-based article, the reality of deteriorating operating earnings would have been mentioned and the special factors described above would have been brought to the attention of readers.
This meme that Bloomberg and IBM management are propounding is that IBM is a bargain, given alleged record EPS. This was made clear by the ending of the article:
IBM is the worst-performing of billionaire Warren Buffett's top investments at Berkshire Hathaway Inc. (BRK/A) Buffett wrote last year in a letter to shareholders that long-term investors like Omaha, Nebraska-based Berkshire should cheer for IBM shares to languish in the short term. A lower price means IBM can repurchase more of its stock, increasing Berkshire's ownership stake in the company.
Buffett didn't respond to a request for comment sent to an assistant today. In an interview last week on the "Charlie Rose" show, Buffett said he's confident in IBM's prospects.
"They will have record per-share earnings this year," he said. "That can be disappointing if you expected more. But it is not a bad record, believe me."
It is unclear whether IBM will have record per-share earnings this year if one includes the large severance charge(s). EPS are however not the key to a stock's attractiveness, no matter how much the financial media emphasizes that single metric. All sorts of variables such as sales per share, book value, tangible book value, debt load, sales growth, competition, R&D productivity,etc., are what determine a company's current value and its ability to produce future profits. Beyond what numbers can measure, there are the intangible values such as corporate culture and sense of mission that may be even more important than that which can be quantified.
IBM is doing what troubled large companies often do, which is point to their famous brand names and use their allies in the media and the financial establishment to promote the stock while they are losing ground to stronger competition. What IBM executives do not do is buy the stock that Mr. Buffett and implicitly Bloomberg.com recommend. From Yahoo! Finance:
Insider Transactions Get Insider Transactions for:
Net Share Purchase Activity
Insider Purchases - Last 6 Months Shares Trans Purchases N/A 0 Sales 231,553 20 Net Shares Purchased
(231,553) 20 Total Insider Shares Held 1.1M N/A % Net Shares Purchased
In the prior 6 months, this data indicates that insiders bought no stock and sold 17.4% of the shares they held (the small amount of 1.1 million). Yet their pitch to you and me is that they have such confidence in the future that the best use of corporate cash and debt is the company's stock rather than expanding R&D and/or sales efforts. But they do not eat home cooking.
This is unfortunately representative of the investment times we are in. It is similar to what occurred in the late '90s. Insiders sell. Short-sellers get squeezed. As a long-only investor, my strategy is simple. It does not matter to me where IBM shares trade so long as there is no operational excellence or actual real tangible value in a Benjamin Graham sense. I do not wish IBM shares ill. I just watch them and wait for the company to grow operating profits again.
Long term holders of IBM shares may do fine, and of course the company has huge resources to effect a turnaround, but prospectively, I believe that new money has more attractive investments based on what we know.
Gradually, IBM is shrinking in importance relative to the high tech universe. Apple (AAPL) will sell this quarter more than half of IBM's entire 2013 revenues. Relative newbie Cisco (CSCO) will do half of IBM's revenues in its current fiscal year. Next year, Amazon's (AMZN) sales will near those of IBM. And so on.
Conclusion: It would be an exaggeration to say that I view IBM as ready to go fetal and stop competing, or that I have a directional point of view on the stock for any particular time frame (though I think $130 would be a reasonably attractive price for the stock based on current fundamentals). My view on the stock, again, is simple. I view it as unattractive for new money. As a non-IBM shareholder and not being an investment adviser, I have no opinion on what existing IBM shareholders "should" do. In my 35th year of investing, I have concluded that past patterns are often prologue. IBM appears to be putting more emphasis on its stock than on its actual business performance. This is the opposite of how Steve Jobs led Apple's revival after returning to it in the 1990s. Thus I want to see actual operational excellence across the corporation before I buy the shares.
What we are seeing in IBM's behavior, and the media that applauds its financial engineering, is not limited to IBM. Readers may wish to explore that meme while stocks as a whole are at near-record valuations despite slow corporate sales growth. Perhaps companies with solid balance sheets and nicely growing profits that also have tiny investor relations departments may be especially interesting for new money buys.
Additional disclosure: Not investment advice. I am not an investment adviser.